The federal government first made the Tax-free Savings Account (TFSA) available to Canadian investors in January 2009. These accounts let you earn investment income — including interest, dividends and capital gains — tax free. You could contribute $5,000 in 2009 to start your Tax-free Savings Account.

Every year until 2013, you could contribute an additional $5,000 to your TFSA. If you contribute less than the maximum to your TFSA in any given year, you can carry the difference forward. That means your TFSA contributions for 2009 and 2010 totalled $10,000, rising to $15,000 in 2011, $20,000 in 2012 and so on.

As of January 1, 2013 the annual contribution limit increased to $5,500, in line with the initial promise to adjust limits with rising inflation. It remains at $5,500 for 2015. That means that if you haven’t contributed yet (and were 18 years or older in 2009) you can now contribute up to $36,500. At some point, once the federal books are balanced, the Conservative government is on record that it will boost the annual TFSA limit to $10,000.

How to shelter your gains with a Tax-free Savings Account

Use your TFSA to complement your RRSP.

Generally speaking, your TFSA can hold the same investments as an RRSP. This includes cash, mutual funds, publicly traded stocks, GICs and bonds.

Contributions are not tax deductible, as they are with an RRSP. However, unlike withdrawals from RRSPs (or withdrawals for RRIFs to which most RRSPs are converted), withdrawals from a TFSA are not taxed. In this respect, RRSPs and TFSAs are mirror images of each other in the way they impact your taxes.

This makes the TFSA a good vehicle for more short-term savings goals, like saving up for a down payment on a first home. If funds are limited, you may need to choose between RRSP and TFSA contributions. RRSPs may be the better choice in years of high income when you’re in the top tax brackets, since RRSP contributions are deductible from your taxable income. In years of low or no income — such as when you’re in school, beginning your career or between jobs — TFSAs may be the better choice.

Investing in a TFSA in low-income years will provide a real benefit in retirement. When you’re retired, you can draw down your TFSA first, incurring zero tax liabilities. After that, you can begin making taxable RRSP withdrawals.

… contributing as much as $5,500 to your TFSA (Tax Free Savings Account) if you’re Canadian. Launched at this time in 2009 and behaving somewhat like America’s “Roth” IRAs, it’s hard to believe this is already the seventh time you can contribute. By my calculations, that means $36,500 of collective contribution room plus any investment growth. That’s four years at $5,000 and now three years at $5,500: the maximum was boosted by $500 as an inflation adjustment for calendar 2013.

So if you’re one half of a couple, that means $73,000 in joint contribution room, even if you left it in interest-bearing investments paying almost zero. If you’ve been investing mostly in equities (either stocks or equity ETFs), it’s likely your TFSA had reached $40,000 or more by year-end, so it’s quite conceivable that some couples now have close to $100,000 invested in TFSAs between them.

Thursday, Jan. 1 was of course a holiday. While Friday, Jan. 2, 2015 is likely to be a quiet day for most, there’s no reason why you can’t contribute the next $5,500 to your TFSA that day, particularly if you use online banking and/or discount brokerages.

Good place for equity ETFs

What to invest in? In retrospect, those who invested in US investments with unhedged exposure to the US dollar would have done best up till now. Our daughter’s TFSA is more than half invested in US tech stocks and broader ETFs and the exposure to the greenback has boosted her TFSA to several thousand more than our own TFSAs with more exposure to the loonie.

Generally, I think a Couch Potato approach to investing in TFSAs makes the most sense, using broadly based ETFs from firms like Vanguard or iShares. Those closer to retirement may want a healthy exposure to Canadian dividends: foreign dividends will lose a bit of withheld tax in a TFSA and are better held in RRSPs for that reason. But for younger investors it may make sense to hold non-dividend paying US tech stocks in a TFSA for both the extra growth potential and the exposure to a strong US dollar that is showing no signs of weakening.

I still say the TFSA and Roths are the best games in an over-taxed town. While it’s true that many had hoped the 2015 limit would be more than $5,500, remember that unlike RRSPs, you can continue to contribute to TFSAs well past age 70 or 71: in fact, if you live that long you could still be contributing if you’re a hundred or more.

The key is to get the money in there as soon as you can and let it grow. And that means early January each and every year. While I think the benefit is particularly powerful for the young, they should balance the growth potential with debt repayment. There’s not much point in paying close to 20% a year in credit-card interest if you’re only earning 2% interest in a GIC or cash equivalent contained in a TFSA.

As I noted Thursday in this blog and elsewhere, I’ve always believed Canadians should have higher RRSP contribution limits and/or the equivalent space in registered pension plans.

It seems the C.D. Howe Institute agrees, based on this paper released Thursday, and which has already created a fair bit of publicity. I’ve received some email on this site (via jonathan@findependenceday.com) to the effect that “only the rich” benefit from more RRSP room and that, in any case, low-income earners are better off with TFSAs.

I’ll quote from some of the skeptics below, but first let me reiterate the point that Ottawa will eventually get any tax revenue it may lose by raising RRSP limits now. As any retiree with a substantial RRIF knows, forced annual RRIF withdrawals will be fully taxable and may even result in the clawback of OAS or other benefits. That’s why some question my statement that higher-income earners should welcome more RRSP room.

Two pluses, one minus

I know those with big RRSPs will eventually pay the piper but remember two things. One, several years or decades of deferred and compounded growth on investments is worth a lot. Second, most of us can expect to be in a lower tax bracket in retirement than when we were working. If you can defer tax while you’re in a 46% tax bracket and pay it many years later when you have no other income and are in a 23% tax bracket, that to me is a fair trade.

A 72-year old reader with the first name James makes the following counterpoints:

… when the other shoe drops and you are withdrawing money, here are the nasty realities:
1. You may be paying higher tax rates than when you put it in! This is true in my case and you do not have to have amassed a huge fortune for that to occur.
2. The whole nasty business of clawback, which has huge potential marginal tax rates.
3. The fact that the government controls the rate at which you reacquire your own money – regardless of your needs and limitations.

Any reform of RRSPs therefore should not only deal with maximum deposit limits but should remove any restriction on the amount and the timing of withdrawals. If I want to leave it in there until I die I should be able to and it can then by taxed in my estate (as a lump sum, which the government would love!) or passed on to one more generation – the spouse.

In the absence of hard numbers on this situation, I tried very hard to come up with my own scenarios using a sophisticated hand-held financial computer, and concluded it was better to collapse my entire RRSP before my 72nd birthday, but I may be on shaky ground without stronger financial planning tools than I had access to.

What if we didn’t tax CPP and OAS benefits?

Another reader, James from British Columbia, makes a suggestion that has occurred to me in the past. Instead of introducing an expanded CPP that will antagonize employers by in effect hiking their payroll costs, why not just make CPP and OAS income go further in old age by not taxing the income?

There could be a means test to apply some tax rate for high income earners, as there is now on OAS, but people who earn under $75,000 per year, for example, would pay no taxes on CPP and OAS benefits.

That simple, stroke-of-the-pen policy change by Ottawa would boost retirees incomes by at least 15% on those sources and not cost a single job. Nor would it require any provincial consensus.

It would cost Ottawa tax revenue, so of course it’s a nonstarter, but it’s not difficult to eliminate the job-killer argument if the federal government really has the will to help low-income retirees.

I’ve long argued that the best tax shelter out there is the Roth IRA in the United States and its equivalent launched in Canada five years ago: the Tax Free Savings Account or TFSA.

Now, you could argue your own business is superior tax shelter and possibly a principal residence. But for ordinary folk earning salaries I still prefer TFSAs or Roths. Note that in Findependence Day, depending on whether it’s the Canadian or US edition, TFSAs and Roths get a lot of space.

The reason why can be based on the original term for the TFSA before it was finally unveiled in 2009: Tax PrePaid Savings Plans or TPSPs. The problem with RRSPs or IRAs is that while you get an alluring tax deduction up front, one day the piper has to be paid: in retirement, with traditional RRSPs/RRIFs and their American equivalents, you have to pay tax on withdrawals, just as you must with traditional employer pensions.

Tax-prepaid means no double taxation

Not so TFSAs and Roths. As the original name suggested, the tax has been PRE-PAID. What does that mean? In Canada, to contribute the annual $5,500 permitted into a TFSA, a top bracket earner might have to generate $7,000 of earned income, paying roughly $1,500 in income tax, and THEN contribute the remaining $5,500 into the plan.

But having done so and paid tax once, you’re now free and clear: there’s no double taxation, as is the case in taxable or “non-registered plans.” And that’s why I think they’re a good idea, but only if you take the trouble to optimize them and maximize their long-term growth. And remember, not only do you not pay tax when the money is withdrawn, but you also never pay tax on the interest, dividends and capital gains generated in the plan.

Sweet! This was the subject of two columns I wrote the past week for the Financial Post. You can find the first here and the second here.

One of the first acts of the new year for our family was topping up our Tax Free Savings Accounts or TFSAs. You’ll see a number of TFSA stories running this week on the MoneySense.ca web site, some of them from the most recent edition of MoneySense magazine, which I edit. Julie Cazzin’s feature story on the Great TFSA Race should whet your appetite on the potential of this vehicle, with the winner racking up an incredible $300,000 in his TFSA, and runnerups at $72,212 and $61,700.

Of course, such returns can come only from capital gains on shrewdly picked stocks, and probably concentrated positions in relatively risky smaller stocks. If you make the mistake of parking your TFSA in GICs or some version of cash, your growth will be negligible. Assuming you put in $5,000 in January 2009 and maxed out every year thereafter, with $5,500 a year ago and $5,500 early in 2014, you would now have $31,000 cumulative contribution room: six years worth. Of course, if you’re one half of a couple, then your spouse also has $31,000 room for a combined $62,000. That’s what I would call significant money: enough to buy a luxury new car or to put a down payment on a first home.

TFSAs are too good to use on spending

However, the tax allure of TFSAs is such that it seems a terrible shame to have to actually spend the money, when its potential to grow into a huge nest egg is such an enticing alternative. Fortunately, the bitter pill of breaking into capital is sweetened somewhat by the fact you can replenish the TFSA, so you’re not actually losing contribution room. Because you can’t repay until the following year, however, you’ll keep more tax-free growth by cashing out towards the end of a calendar year, rather than early in the new year.

Note that in the case of the big winners of the TFSA Race, the bigger the TFSA when you cash out, the more contribution room you’ll eventually have when you recontribute. So in the case of Jim Nykyforuk, if he were to take his entire $300,000 out this year, in 2015 he’d be able to recontribute the same $300,000, plus of course the new $5,500 room he and everyone will qualify for by January 2015.

Those are big numbers but as I wrote in the editor’s note for the current issue (Dec/Jan 2014), it’s unlikely that most TFSAs will have grown anywhere near that much, even if they are in stocks. The risk-takers who won the contest had plenty of other money in other vehicles and they were willing to risk the TFSA capital for a big win, fully understanding it’s as easy to strike out as hit a grand-slam home run.

Diversified equities more prudent

I wouldn’t even recommend that most people emulate those aggressive strategies. From my correspondence with the kind of readers who gravitate to a “Couch Potato” portfolio so often seen in the pages of MoneySense, a typical all-equity TFSA would have grown from the original $25,500 contribution room to somewhere in the low $30,000 range at the end of 2013. In our family, for example, our TFSAs ranged from $32,000 to $34,000 and as of the January 2014 top-up would be just shy of $40,000 each. (This includes our daughter, whose aggressive investing strategy was unveiled in MoneySense in an earlier feature by Julie: How TFSAs can make your child a millionaire; Dec/Jan 2013)

The temptation to dip into such growing nest eggs must be considerable for younger people but when you consider the power of tax-free compounding, I’d still urge most to keep their hands off their TFSA for 30 or 40 years. Yes, those who have maxed out to this point now have enough to buy a brand new car, but I’d urge them to instead go with a used vehicle or take advantage of zero financing or ultra low interest rate deals on new cars. The other big temptation would be to dip into TFSAs for a down payment on a home but here again, I’d look first at the Home Buyer’s Plan provision of RRSPs first, or perhaps hit parents up for a down payment.

TFSAs should be priority for those with modest incomes

I’d think most MoneySense readers are in a position to do BOTH an RRSP AND a TFSA contribution but for those who aren’t, the TFSA should probably get the nod. If you can’t do both, odds are your income is relatively modest, in which case you may be in a lower tax bracket, which in turn makes the RRSP argument less compelling. By the same token, if your salary is relatively low and you want to maximize future sources of government retirement income like Old Age Security and/or the Guaranteed Income Supplement, then again the TFSA is compelling: all withdrawals will be totally tax free and not trigger dreaded “clawbacks” of OAS or GIS. Say you’re currently 47 years old and have $10,000 saved in a TFSA. In 20 years, you could contribute $5,500 20 times, for another $110,000 (and probably more if the government keeps adjusting the limit to inflation.) Even if growth was negligible because it’s invested in laddered 5-year GICs or a bond ETF equivalent, let’s assume you can get 2.5% interest (a figure that will likely be much higher 20 years from now.)

Even with no employer pension or other sources of income, someone living on some combination of CPP, OAS and GIS taken at age 67 would be able to generate some $3,250 a year of safe interest income from a nest egg that (conservatively) might have grown to $130,000 over that time. That’s almost $300 a month, guaranteed and tax free.

If you put it into Canadian blue chip stocks, you’d have a much bigger nest egg but either way, it’s nice to have an emergency fund and a source of regular income that’s independent of what government authorities provide — my idea of a modicum of financial independence even for those with modest means. Yes, I realize it’s tough for some to put aside even $5,500: if that’s the case, then at least shoot for $2,000 or $3,000 a year, even if it means going without expendable luxuries like alcohol, tobacco, fine dining, lottery tickets or even the much maligned daily latte habit at your local coffee shop. Find just $50 a week for your future and you’ll be on your way!

As for dual-income couples making good money, to me it’s a no-brainer that the TFSA should be maximized each and every year, and managed for maximum (or balanced) growth. The moment you make your January contribution, you should start accruing for the next year’s installment, even if it means parking in short-term cash vehicles and paying a little tax for the balance of the calendar year.

While the pre-budget hype was that Canadian baby boomers were going to have to delay their retirement after Thursday’s federal budget was unveiled, their Findependence Day has not been severely postponed for anyone who is now 54 years old or older as of March 31, 2012.

As expected, the Old Age Security eligibility age will rise gradually from the current 65 to 67 but this doesn’t start to happen until 2023, according to the just-released budget. When you add the 11-year notification of this change to the six-year phase-in between 2023 and 2029, I’d agree with Finance Minister Jim Flaherty that Canadians [or their financial planners] have “ample time to make adjustments to their retirement plans.”

For younger people born on or after Feb. 1, 1962, OAS eligibility will be age 67. Technically, boomers were born between 1946 and 1964 but in my view, if you were born between 1962 and 1964, you likely didn’t grieve over the JFK assassination and can hardly be considered a true baby boomer.

In addition to November being Financial Literacy Month, this week is also Credit Education Week. On Tuesday at the YMCA in Toronto, as part of the launch of Credit Education Week, I gave the following talk which touched on all of credit, financial literacy, the sandwich generation and of course financial independence. All recipients at the talk received copies of Findependence Day courtesy of Capital One.

Here’s the text of the talk:

Dreamfilm.ca

Laurie had asked me to talk today about the Sandwich Generation. I’ll do that and also talk about life cycle financial planning and the concepts behind “findependence” or financial independence.

Some of you may remember around the turn of the millennium, the National Post distributed four issues of a glossy magazine I helped create, called The Wealthy Boomer.

Well, it just so happens that the final issue featured a cover story on the Sandwich Generation.

We’d commissioned a nice if predictable cover that depicted a frazzled middle-aged baby boomer tearing out her hair as she attempted to grapple with the conflicting demands of an aging parent and screaming children.

I could relate to that at the time because in 2000, we had a nine-year old daughter, four parents and two busy careers. Today, however, daughter is 20 and away at college, and all four grandparents have passed away.